A Dangerous Game Of Chicken

Posted on August 27, 2013

“Let me reiterate what our position is, and it is unequivocal. We will not negotiate with Republicans in Congress over Congress’ responsibility to pay the bills that Congress has racked up, period. We have never defaulted, and we must never default. That is our position, 100 percent, full stop.” - White House Press Secretary Jay Carney

After a relatively quiet 5-week summer recess, we expect the conversation in Washington to heat back up once Congress is back in session on September 9th. With exactly three weeks remaining in the fiscal year, the house, senate and white house will have to work together on a FY2014 spending plan or face a government shut down on October 1st. That said, while a potential shut down may have seemed a viable threat two summers ago, no one seems to give it much credence now that we’ve been to the edge and back multiple times since 2011.

There remain deep disagreements within the two chambers and the white house over how the nation’s finances should be managed. The republicans hold a bias towards lower taxes and addressing the fiscal deficit through targeted spending cuts and defunding Obamacare. The democrats, meanwhile, would close the gap via higher taxes on top earners while trying to stimulate economic growth with sustained government spending and transfer payments. Given these differences, passing an actual budget does not seem a legitimate possibility at this point. We will undoubtedly see another continuing resolution that preserves the status quo and keeps the government funded with no changes for a set period of time. In this way, the republicans can force Obama to continue dealing with the highly inefficient spending sequester that he signed into law in 2011 while the democrats can preserve and shelter Obamacare in its current form.

Okay, fine. So we kick the can down the road and can breathe easy for another couple months until we have to deal with the debt ceiling, right? Wrong. In a letter to House Speaker John Boehner yesterday, Treasury Secretary Jack Lew revealed that the country is projected to hit its legal debt limit of $16.7 trillion much sooner than expected – in mid-October. This means the budget debate of September is going to simply bleed over into the debt ceiling debate of October.

And we expect the debt ceiling debate to turn into nothing short of a dangerous game of chicken. It’s no secret that congressional republicans want to use the debt ceiling as leverage to force some changes, if not a wholesale defunding, on Obamacare. At the very least, Speaker Boehner has continually reiterated that he is unwilling to raise the ceiling without proportional cuts in spending. Meanwhile, the President has set a pretty clear expectation that he is simply not open to any discussion on this topic (see opening quote). This is why political characters such as Jack Lew are beginning even now to try to pre-empt a crisis by appealing for compromise and cooperation. In his letter to Boehner, which can be read in its entirety here, Treasury Secretary Lew pleads his case by arguing that a failure to raise the debt ceiling would “cause irreparable harm to the American economy”.

There is a real possibility that this game of chicken could derail the Smooth Sailing that we’ve seen in global financial markets for the majority of this year. Business and consumer confidence is so crucial to the economic recovery right now, and the last thing we need is a flurry of disturbing front page headlines about a government shutdown or a US default. Furthermore, the Federal Reserve is widely anticipated to begin tapering its asset purchases beginning with its mid-September meeting. If the economic recovery is being thrown into question by congressional cat fights, financial markets will struggle to find their footing as they attempt to anticipate and then interpret the Fed’s actions against the backdrop of uncertainty in Washington.

Diversification 2.0 should be a powerful defense against such uncertainty, as there are multiple scenarios under which bonds and gold could gain back a portion of their year-to-date losses even as equities falter from recent highs. We have already begun to see signs of this, with today’s market action being no exception. If we’re right, this would be a welcome departure from the Taper Tantrumregime in which all the asset classes were moving in tandem with each other in response to Fed tapering expectations. In other words, broad diversification is one of the only ways to opt out of playing this dangerous game of chicken and not being dependent on any one scenario playing out in order to preserve capital and generate positive returns.

Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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